Gary Gensler: Remarks at "Off" The Chain Summit


Gary Gensler

Blockchain Technology Potential

Blockchain technology has a real potential to transform the world of finance.

To reach its potential, though, blockchain technology and the crypto ecosystem it has birthed, must come fully within public policy frameworks.  Living within these policy goals has helped foster for decades traditional capital markets and are just as important for the crypto markets, even if the details for achieving these goals may change.  More specifically, the public broadly benefits when our societies: 

  • Ensure for tax compliance
  • Guard against money laundering or terrorism financing 
  • Promote financial stability
  • Protect consumers and investors
  • Promote efficient capital markets
  • Foster economic inclusion and growth

Though there are many technical and commercial challenges yet to overcome, I’m an optimist and want to see this new technology succeed. 

Blockchain technology could lower costs, risks and economic rents in the financial system.

As things currently are, though, there is significant non-compliance in the crypto field, particularly with initial coin offerings, other tokens and crypto-exchanges.

Crypto Exchanges
Once Bitcoin developed as the first cryptocurrency, it was only natural that secondary markets and exchange trading would soon develop.

To date, however, this trading activity has largely taken place outside of investor protection and market integrity regimes. 

Since 2010, hundreds of crypto-exchanges have started, and many have failed.  

Trading is significant, with the top ten platforms reporting over $17 billion in daily volume yesterday.  There are now approximately 200 crypto-exchanges with some trading volume.

Exchanges also have tens of millions of customers worldwide. Coinbase has over 13 million active accounts opened, more than brokerage firm Charles Schwab.

Like traditional securities and derivatives exchanges, crypto-exchange offer trade matching services and order books to their customers. They also offer a wide range of market making, advisory and custodial services.

They have some significant differences, though, from traditional exchanges.  Crypto-exchanges offer direct access to customers rather than access through intermediaries.  Thus, customers’ crypto funds are held in custody by the exchanges, usually in digital wallets, rather than being held at a bank, broker dealer, or future commission merchants.

The question now is: How?
In the US, it is no longer a question of ‘if.’ 

It is no longer a question of “when.”

Crypto-exchanges trading ICOs and other tokens deemed securities must comply with securities, laws. Exchanges trading crypto derivatives or related leveraged crypto assets must comply with commodities and derivatives laws.

The path forward and the pressing question now is, ‘how?’

Lessons from the Internet
We’ve seen questions like this before, with the broad adoption of the Internet in the 1990’s. 

The SEC introduced Regulation ATS in 1998 to address new trading protocols emerging on the Internet. 

In the name of promoting innovation, though, some actions came back to haunt the public.

New means of trading swaps electronically emerged and along with them exemptions for trading platform - which came to be known as the ‘Enron loophole’.

The Path Forward
So, how do the markets, this new technology and regulators go forward? 

Let’s review a set of 4 general considerations for both exchanges and ICOs and then a set of 5 specific crypto- exchange considerations.

General Considerations
First, how might regulators bring over 100 exchanges into compliance? 

Might retroactive registration work in practice?  In particular, should exchanges which were operating outside of investor protection norms and might have profited from front running or manipulating markets, be allowed to register? 

Who might stand behind any rescission rights?

Some requirements will be difficult for these crypto-exchanges.  For example, how might broker dealer requirements fit onto existing crypto exchange operations?

Operating an exchange which trades unregistered securities such as most ICOs, though, would be a current violation. 

There is a strong case that some large market cap tokens, such as ETH and XRP are non-compliant securities.  How might exchanges offering trading in these tokens adjust their operations or listings?

Recovering Losses
Second, though U.S. Securities laws provide private rights of action, how might regulators and the courts help investors recover losses on trading on unregistered non-compliant exchanges?

Compliance and Possible Tailoring of Crypto Regulations
Third, how might crypto-tokens going forward comply with existing laws? 

Might the law be tailored to take into account the novel circumstances of this new technology, while still protecting consumer and investor interests? 

Tools in Regulatory Toolkit
Fourth, which tools in their toolkit might regulators use?

They’ve used public advisory statements, speeches, testimony and enforcement actions but will they issue rules and interpretations specific to the crypto space.

This presumes that some tailored crypto regulations are appropriate. 

It also takes significant time.

Specific Considerations – Crypto-Exchanges
There also are a number of specific areas for consideration related to crypto-exchanges.

Custodial Duties
First, crypto-exchanges have had significant challenges in protecting customers’ funds.  Numerous hacks have led to significant losses of customer funds.  Mt. Gox lost $473 million in Bitcoin in 2014.  Coincheck lost $530 million in NEM (XEM) tokens in 2018.

The key question is how will custodial duties be fulfilled?  At the SEC, the segregation and custodial duties of broker-dealers will apply?  Under CFTC jurisdiction, will it be looking at custodial requirements for retail foreign exchange dealers (‘RFED’), futures commission merchants (‘FCM’), or possibly those for commodity warehouses held by designated contract markets (‘DCM’)?

How might blockchain technology, public keys and cryptography play into existing rules?  Might new technologies, such as multi-signature controls protect customers or fulfil custodial responsibilities?  What added safeguards, might be appropriate for the private keys associated with exchanges’, asset managers’, banks’ or regulated intermediaries’ public keys? 

What additional cyber-security and other safeguards might be appropriate, particularly given the numerous losses and hacks that have occurred in the past?

Market Integrity
Second, what type of investor protection and market integrity rules will apply?

Often acting as counterparties to their customers, crypto-exchanges currently have limited guardrails against front running, fraud, or other manipulative practices.  For instance, there are no assurances that order book or sales price information posted on these exchanges are currently accurate.  One academic study suggests that the Mt. Gox exchange may have manipulated the price of Bitcoin up 8-fold in 2013.[1] 

Registration will bring exchanges into regimes promoting transparency, segregating customer funds, guarding against conflicts of interest, and promoting market integrity.

Decentralized Exchanges
Third, how would registration and regulation be applied to decentralized crypto-exchanges?  Using blockchain technology, a number of exchanges facilitate peer-to-peer trading through algorithms without a centralized exchange.  This raises a number of novel questions?

In particular, if an exchange is but a distributed, open-source software protocol, where and how might a registration requirement be applied?  How might regulatory requirements be enforced?  For those decentralized exchanges that have a sponsor company, might it be appropriate to attach requirements to that company? 

Would there be any gaps in enforcement?  If a decentralized exchange traded fiat vs. cryptocurrency pairs, regulators might be able to use the banking system to affect policy at these exchanges, through the fiat money on-ramps and off-ramps of the exchanges?  Maybe regulated intermediaries should not be allowed to transact on such platforms?  There are legitimate concerns that crypto-to-crypto decentralized exchanges may try to operate outside of the regulatory oversight.

Financial Stability, Illicit Activities
Fourth, how can regulators ensure that crypto-exchanges do not lead to financial instability or increased illicit activity?  Many international jurisdictions are moving to require that exchanges comply with anti money laundering, combatting financing of terrorism, and know your customer laws.  Will this be enough?  In the U.S., in the absence of federal registration, crypto-exchanges are required to comply with money transmission laws and register in the individual states.  If exchanges fail to do so, they likely are violating federal law.

Further, absent intermediated access, tax authorities and financial crimes enforcement must rely solely on exchanges, investors or blockchain forensics companies, for reporting on crypto transactions, taxable gains or losses, and any illicit activity.  Decentralized exchange protocols, particularly for crypto-to-crypto trading, raise significant additional compliance challenges.  

How can we ensure, though, that crypto-exchanges don’t add to instability, particularly in volatile or uncertain markets?  Given that so many exchanges remain unregulated and lack transparency, how do Central Banks and others responsible for financial stability get an accurate window into these markets?

Type of Registration
Fifth, which type of registration is appropriate for crypto-exchanges? 

For those offering trading of ICO launched tokens deemed to be securities, they will need at a minimum to register as broker dealers and operate as ATSs.  As an ATS, there also would be a requirement to join a self-regulatory organization.

If ETH or XRP are deemed to be investment contracts under U.S. law, then nearly all existing exchanges would require SEC registration.

Once registered, what trade reporting rules would apply to tokens trade on these platforms?  Might ICO pricing be fed into a national market tape?  How would access be granted and achieved with other exchanges? 

If an exchange offers trading in crypto derivatives on cryptocurrencies, then that exchange must register with the CFTC.  Crypto-exchanges that offer to U.S. persons ‘retail commodity transactions’ as defined in statute, could also be subject to the authority of the CFTC.  Might these registrations be as a DCM, as aswap execution facility (‘SEF’), or as an RFED?

Depending upon final CFTC guidance on the definition of ‘actual delivery’ of commodities underlying trading on crypto-exchanges, it is possible that many non-securities related exchanges will be required to register with the CFTC.  Further, as the CFTC has general anti-fraud and anti-manipulation authority for commodities, would they seek to use this general authority to write rules for trading on crypto-exchanges?

In conclusion, blockchain technology has real potential to transform the world of finance.

It could lower costs, risks and economic rents in the financial system.

Crypto-exchanges have grown rapidly recently and have had considerable problems with hack of customer funds and with market integrity.

For broad adoption crypto-exchanges need to come within existing public policy frameworks.

Clear rules of the road will protect investors and allow firms, both incumbents and start-ups, to more fully explore investing in crypto tokens and related crypto exchanges. 

Further, until such clarity is brought, incumbent financial firms will face a competitive disadvantage relative to startups.  Incumbents will not risk being noncompliant when entering this market.  In contrast, many startups have jumped in, though taking on the significant regulatory risks of being non-compliant.

All crypto-exchange operators should now be talking with the SEC and CFTC and seek to comply with the law to fullest extent possible.

The public, blockchain technology, and the financial system will all reap the benefits.

[1] Price Manipulation in the Bitcoin Ecosystem; Neil Gandal, JT Hamrick, Tyler Moore, and Tali Oberman (June 22, 2017)

Delivered at the "Off" the Chain Summit held April 26, 2018.

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